ARR Waterfalls Can Get Messy

July 27, 2022
24 Minutes
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In SaaS businesses, operating results are earned every single day; and good businesses are made, not found. Writing here about building organizations, learning from the experience, and appreciating the ride.

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Over the past decade, the “ARR waterfall” or “SaaS revenue waterfall” has become a mainstay within the landscape of SaaS metrics and reporting. This is hardly surprising: operators, investors, and analysts all need a commonly accepted standard for assessing the topline performance of SaaS businesses; and the ARR Waterfall conveys so much in only a few lines (for this reason, I’d submit that the ARR waterfall is essentially the haiku of SaaS reporting…but I digress). As in the example below, an ARR waterfall neatly ties together new bookings, upsell, contraction, and churn into a structured, easily digestible story around the surprisingly complex question of how much net Annual Recurring Revenue (ARR) a business adds in each period.

Example ARR waterfall
Example ARR Waterfall

We also like a purely graphical / summary representation of this table, which is likely the source of the term “waterfall:”

Example Graphical ARR Waterfall
Example Graphical ARR Waterfall

This all works well in a prototypically tidy SaaS business: clients pay a specified amount for subscriptions to use a SaaS solution over a designated period, renewing that commitment at regular intervals. These renewals typically take place on an annual or monthly basis (or do NOT take place, resulting in “churn” or “drops”). Likewise, this quintessential SaaS business tends to offer graduated packages (“Good / Better / Best”) of its solution and/or allows customers to add or remove modules on top of a base subscription (“Core + More”). These add-ons lead to ARR expansion (aka “upsell”) but can also result in contraction when customers elect to scale back their licensed capabilities (aka “downsell”). In this scenario, new bookings, upsell, contraction, and churn all tend to be discrete, knowable, and quantifiable figures…in other words, comfortingly black-and-white.

The dirty secret within many SaaS businesses, however, is that the world is a lot messier and more complicated than ARR waterfalls would make it appear. Below are just a few examples of common nuances, along with the inevitable Good, Bad, and Ugly that each represents to SaaS providers trying to craft a tidy ARR waterfall — and, finally, some closing thoughts around how to manage such messiness:

· What if your business offers usage-based pricing, whereby clients get billed based on an amount of actual usage over a given period? Note: usage can be measured in countless ways (number of users, volume of transactions processed, database calls executed, and others).

Bad: There are a few downsides here: First, it’s difficult to estimate at the time of initial sale what a client’s exact usage will ultimately be (and, by necessity, they get billed in arrears). Second, customers can decrease consumption (and, in turn, fees paid to the vendor) at any time.

Good: The upside is that customers can effortlessly increase usage/users as their appetite for the solution expands. In this way, value/performance is rewarded with ever-increasing client consumption (and correspondingly rising fees).

Ugly: Unlike traditional flat or tiered subscriptions, no indisputable dollar amount is tied to a new booking (sale). As a result, businesses need to estimate both expected future usage and also the timing of how that usage will ramp. At best, this is an inexact art/science that complicates the ARR waterfall.

· What if a benefit of your SaaS offering is the ability for clients to terminate contracts at their convenience and/or that these are evergreen contracts with no set renewal date?

Bad: Vendors cannot contractually “lock in” customers for a specified period in this model, which tends to freak out SaaS investors.

Good: Customers no longer face a lengthy commitment up-front, thereby reducing friction in the initial sale. Likewise, clients have no contractual end date forcing them to evaluate whether or not to continue using a SaaS solution. This can benefit vendors, particularly in disruptive economic periods, as we saw in the early days of the pandemic.

Ugly: This approach can camouflage churn. Because there is no set renewal date, churn can appear artificially low, even while customers slowly wean down their use of the solution over time. The result is a blurring of the lines in the ARR waterfall between contraction and churn.

· What if there is a mix of pure subscriptions (where clients manage their use of the software) along with technology-enabled reoccurring managed services (where the vendor provides admin and management of the solution on customers’ behalf)?

Bad: The downside of this approach is that the unit economics of these two offerings can differ significantly (i.e., managed services generally have a lower gross margin).

Good: The upside is that offering a managed service can open up new segments, particularly among smaller, less resourced customers who will more readily adopt a solution with ongoing admin assistance from the vendor.

Ugly: This situation introduces complexity in the sales cycle and also in terms of cost tracking. In this situation, not all ARR is the same, which undermines the tidiness and related utility of an ARR waterfall.

Before going any further, I’d offer that these situations are surprisingly common in the SaaS world. Many SaaS businesses, particularly those that Lock 8 invests in, offer such contractual nuances that go against traditional commonly accepted SaaS “best practices.” Although SaaS purists tend to poo-poo anything less than straight subscription revenue, customers often appreciate and ascribe value to these nuances (as Jason Lemkin wrote compellingly about here); and smart companies make the conscious decision to manage the tradeoffs described above. Some of the best companies we’ve worked with do exactly that. But…there is a catch. If your revenue model deviates from pure subscriptions, then it’s important to take steps to manage and monitor ARR reporting with great intentionality, as follows:

1. Define: First, be very explicit about defining terms within your ARR waterfall. What EXACTLY do terms like New Bookings, Upsell, and Downsell specifically mean in your business’ waterfall; and how EXACTLY do those terms differ from the commonly accepted usage of those terms.

2. Align / Refine: Explicitly agree among all stakeholders (company leadership, the broader team, the board, and others) on the above definitions and periodically review them to ensure their ongoing validity and usefulness.

3. Baseline: Measure your ARR and all of its contributing elements the same way over time. This will allow the creation of a baseline and offer stakeholders context for truly understanding any future changes over time.

4. Trend line: Always be sure to keep a graphical representation of the ARR over time. For all of us visual learners out there, this is the single best way to actually see how the ARR has evolved and to spot the key trends for the single most important metric in any SaaS business.

Now for the big finish to this post, please queue audio from TLC’s classic, and former Billboard #1 hit, “Waterfalls.” Per TLC’s timeless wisdom: “Don’t go chasing waterfalls”…instead, carefully Define, Align / Refine, Baseline, and Trend Line your own.

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